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It's Just Too Hard

The best way to invest can also be the most difficult.

There's a scene in the 1992 film Scent of a Woman that has to contain one of the greatest movie monologues of all time. It comes near the end, when Al Pacino, as the blind and cantankerous Col. Frank Slade, is defending Chris O'Donnell's character for choosing to protect his friends at the potential cost of his own future. I think it contains some valuable insight into why success at investing can be so elusive:

Now, I have come to the crossroads in my days, and I have always known the right path, always, without exception, I knew. But I never took it. You know why? Because it's too hard.

In life, the most worthwhile path is often also the most difficult. The same goes for investing.

Two essential tricksA few months ago, I had the pleasure of interviewing Joel Greenblatt, a professor of finance at Columbia University and the author of The Little Book That Beats the Market. Greenblatt is the founder and managing partner of Gotham Capital, a private investment partnership that has achieved 40% annualized returns since its inception in 1985.

The methodology that Greenblatt masterfully explains in the book is essentially value investing -- buying good companies that are selling for cheap prices. Duh, you say! Who didn't know that, right?

Value investing is clearly not new. From Ben Graham to Warren Buffett to Mario Gabelli and many, many others, the concept has been employed successfully for a long time. But Goldblatt helps the reader with two crucial ratios that should be investors' primary metrics to determine whether a company is selling too cheaply. The first is return on capital. The second is earnings yield. The former should be as high as possible, while the latter should be at least 6%; that's roughly the average of what a 10-year Treasury has yielded over the past 20 years. When you combine these two ratios, the companies that rack up the highest scores are candidates for ownership.

Using this approach to create a regularly updated portfolio of about 30 stocks with the highest combined rankings, Greenblatt tested his formula between 1988 and 2004. The results were remarkable: With only one down year, the portfolio would have returned 30.8% a year, against a 12.4% annual return for the S&P 500. Diversification is also important, which is why Greenblatt stressed that investors should have at least 20 or 30 of these companies in their portfolios in order to reduce risk.

What you'll needBy now, some of you must be wondering: If this is so great, why doesn't everyone do it? Greenblatt poses that same question in his book. His answer: because there can be periods of time when this approach does not work; when prices languish or worse, when losses accrue. In his book, he writes that from time to time, this can go on for a period of one, two, or even three years. Under those conditions, even the most patient investors will likely be tested.

Waiting for shares of good companies to become cheap takes patience as well. Even when they do get cheap, everyone is second-guessing them. Look at Intel(NASDAQ:INTC), Microsoft(NASDAQ:MSFT), and Dell(NASDAQ:DELL). So many people wanted those stocks when they were overpriced. Now, when they have become true value stocks, you hear every reason in the world why their days are done. (You can draw the same analogy with real estate, recently.)

So why doesn't everyone follow Joel Greenblatt's formula? It's not because it doesn't work. It works just fine. They don't follow it because, as Col. Frank Slade would say, "It's too hard."

Remember my very first article last month, about the four behavioral characteristics? They were patience, detachment, alignment, and discipline. I put patience first for a reason.